Reading 27 – Equity Valuation: Applications and Processes

LOS a - define valuation and intrinsic value and explain sources of perceived mispricing

Steps of valuation process

1. Understand the business
2. Forecast company performance
3. Select appropriate valuation model
4. Convert forecasts into a valuation
5. Apply the valuation conclusions

Difference in analysts determined intrinsic value and market price

IVanalyst – price = (IVactual – price) + (IVanalyst - IVactual)

LOS b - explain the going concern assumption and contrast a going concern value to a liquidation value
LOS c - Describe definitions of value and justify which definition of value is most relevant to public company
valuation

 Fair market value - Price and informed buyer and seller agree to
 Investment value - value to a particular investor

LOS d - Describe Applications of equity valuation

1. Valuation - the process of estimating the value of an asset by

a. Using a model with variables the analyst thinks are relevant
b. Comparing it to market value of similar assets
2. Stock Selection
3. Reading the Market - market price gives a key to what other analysts think about stock
4. Projecting the value of corporate actions - mergers, acquisitions, MBOs, recapitalizations, divestitures
5. Fairness opinions - find fairness of price to minority shareholders in buy out
6. Communications with analysts and investors
7. Valuation of private businesses
8. Portfolio management

LOS e - Describe questions that should be addressed in conducting an industry and competitive analysis

Elements of Industry Structure

1. Threat of new entrants
2. Threat of substitutes
3. Bargaining power of buyers
4. Bargaining power of suppliers
5. Rivalry amongst competitors
Three generic strategies a business can employ
1. Cost Leadership
2. Product Differentiation
3. Focus - employ one of the top two in a particular segment of the industry

Quality of earnings
1. Accelerating or premature recognition of income
2. Reclassifying gains and non-operating income
3. Expense recognition and losses
4. Amortization, depreciation, and discount rates
5. Off-balance-sheet issues

LOS f - Contrast relative and absolute valuation models and describe examples of each

Absolute Valuation Models - determines an assets intrinsic value, which is what arises from its own
characteristics, not other firms
1. Discounted or Present Value
a. Dividend Discount model
b. Free Cash Flow model
c. Residual Income
2. Asset-based models - sum of market value of its assets

Relative Valuation Models - determine its value in relation to value of other assets
 Multiplier modes

LOS g - Describe sum-of-parts model and conglomerate discounts

Sum-of-parts model (break-up value, or private market value) - value individual parts of company and then
sum them up

Conglomerate Discount - the amount by which the market value undervalues the sum-of-parts model
 Caused by
o Internal Capital Inefficiency - companies allocation of capital is not efficient
o Endogenous factors - company may have pursued unrelated acquisitions to hide poor
performance
o Research measurement errors

LOS h - Explain broad criteria for choosing an appropriate approach for valuing a given company

 Does it fit the characteristics of the company?

 Is it appropriate based on quality and availability of input data?
 Is it suitable given the purpose of the analysis?